Why Credit Scores Dropped on New Mortgages in 2013

A new report provides some evidence that it may have become a little easier for some Americans to get a mortgage as the housing market improves and lenders grapple with a pullback in refinancing amid higher mortgage rates.

The average credit score for approved mortgages fell to 727 in December, down from 748 one year earlier, according to a report released Wednesday by Ellie Mae, a mortgage technology firm. (Under a system devised by Fair Isaac Corp., credit scores run on a scale from 300 to 850.)

The report said that some 46% of mortgages that closed in December had credit scores above 750, compared with nearly 57% one year earlier. Meanwhile, around 31% of loans had credit scores below 700, up from 21% one year earlier. Ellie Mae, a mortgage software provider, tracks the characteristics of loans run through its platform.

The data also showed that the average debt loads of borrowers increased. On average, total monthly debt for borrowers whose loans closed in December stood at 39% of their incomes, up from 35% in June and 34% in January. Rising interest rates and home prices could account for some of the increase in debt-to-income ratios.

Why might credit standards appear to have eased, if only very slightly, last year?

First, home prices have stopped falling and the economy is slowly improving, making lenders more comfortable to extend loans.

Second, big drops in refinances, which have slumped after interest rates rose last summer, could also lead lenders to become more competitive for home purchases.

Third, analysts say it is normal for borrowers with weaker credit to seek out refinancing as rates go up and as the refinance cycle nears its end. According to the report, the average credit score on a refinance loan backed by Fannie Mae and Freddie Mac stood at 729 in December, down sharply from 763 one year earlier. There was much less of a drop for new purchase loans, with credit scores falling to 756 in December from 761.

Total average debt-to-income ratios also jumped on refinances, to 41% from 33% a year earlier. There was little change on those ratios for borrowers seeking home purchases.

Some economists believe that, as home prices rise and mortgage delinquencies fall, banks could begin to remove so-called “overlays” that have led them to keep credit standards tighter than what Fannie and Freddie require. So far, however, there are few signs this is happening in any meaningful way on home purchases.

On the other hand, lenders face new regulations that took effect last week governing their legal liability if they don’t ensure borrowers can repay a mortgage. Some economists believe that these regulations will lock in today’s more conservative underwriting standards—particularly those governing lenders’ ability to document borrowers’ incomes and assets.

A separate report released Tuesday from Black Knight Financial Services, a data firm, showed that loans originated last year are performing better than any year since it began tracking such performance in 1997. Some lenders point to this stat as proof that credit standards are too stringent.

But some loan officers say the issue isn’t that credit standards are too tight; instead, they say it’s that many American households are too weak, with incomes that aren’t strong enough to qualify for the amount of debt required to purchase a home. Down payments are also a big problem for many borrowers, either because low interest rates and a weak economy have made it harder to save, or because steep home-price declines from 2006 to 2012 wiped out home equity. Many families use equity from their current homes to trade up, or to help their kids purchase homes.

Borrowers can still qualify for a mortgage with just a 3.5% down payment through the Federal Housing Administration, which has among the easiest qualification rules. The Ellie Mae report showed that the average credit score on an FHA-backed purchase mortgage stood at 690 in December, down slightly from 699 a year earlier. Average total debt-to-income ratios stood at 42% (lenders generally consider anything above 43% to be high).

Credit score averages don’t tell the whole story of who is, and isn’t, getting credit. One prospect is that lenders relax standards for borrowers with higher incomes and larger down payments, even as borrowers with harder-to-document incomes or lower credit scores face additional scrutiny.

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